Valeant scandal shows why we need short-sellers in the stock market

On CNBC, short-seller Andrew Left defends his negative call on Valeant (CNBC)

So, another high-flying company is being pummeled in the stock market. How much do you want to bet that the company's defenders are blaming short-sellers for bringing down another victim?

That's a trick question. The answer has been playing out for the better part of a week, or ever since short-seller Andrew Left of Citron Research, a self-described watchdog of "fraudulent and over-hyped stocks," trained his sights on the Canadian firm Valeant Pharmaceuticals.

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Short-selling is good for the market.

"Reformed Broker" Josh Brown

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The heat Left has taken for putting out useful, but negative, information about Valeant tells you the time has come once again for a primer on short-sellers and their positive role in the stock market. More on that in a moment, but the bottom line is that the market wouldn't function efficiently without them.

First, a brief look at the Valeant case.

Left's initial report focused on an investigation launched by Sen. Bernie Sanders, I-Vt., and Rep. Elijah Cummings, D-Md., into Valeant's business model of massively jacking up the price of drugs to which it had acquired marketing rights. He followed up a couple of weeks ago with a look at the company's curious relationship with a network of pharmacies affiliated with Philidor Rx Services, a mail-order pharmacy suspected of being used by the drug firm to artificially boost sales. That thread started with an investigative article by the independent Southern Investigation Reporting Foundation.

Meanwhile, Valeant shares were cratering, falling more than 62% since their Aug. 5 closing high of $262.52. (They ended Tuesday at $97.86.)

Look out below: Valeant stock has been hit hard since early August. (Ycharts)

So, of course it's Left who has taken most of the heat. Just Monday, CNBC midday host Scott Wapner accused him of "playing on the fears of investors." Left replied, properly, "Fears of investors? I put out information that turned out to be true." Indeed, just last week, Valeant announced under pressure that it would cut ties with Philidor and investigate its own relationship with the pharmacy.

Let's start with a quick definition of short-selling: Basically, it's selling stock that you've borrowed but don't own, and expect to fall in price. The goal is to buy it back later at a lower price and pocket the difference. Think of it as the investment principle "Buy low, sell high" in reverse -- you sell high first, then buy low.

There's nothing illegal about it, even if selling something you don't own smacks, at first blush, of a confidence scheme. Plus, the very idea of someone acting on a cynical hunch undermines the sunny optimism that Wall Street brokers and corporate bigwigs love to peddle to the public. (One of the most prominent--and often right--shorts, Jim Chanos, named his firm "Kynikos Associates"; at last report, he was overseeing $3 billion in assets.)

Short-sellers are a perennial target of CEOs whose stocks are getting crushed--the bosses of Enron, Lehman Bros., and many others have taken their turn blaming short-sellers for downturns in their share prices that ultimately can be traced to their own missteps. As we observed back in 2009, their opinion could be summed up as "Nasty creatures, those short sellers -- always looking at the dark side, raining on every parade."

Shorts are viewed with suspicion and disdain even by ostensibly savvy business mavens. Last year we challenged Steve Pearlstein, a business columnist at the Washington Post, over his assertion that short-sellers were essentially stock manipulators whose work wasn't "all that socially or economically useful."

Pearlstein was defending the D.C.-area firm Northwest Biotherapeutics, whose future was being questioned by short-sellers. Who got the better of that argument? Northwest more than doubled in price to $12.24 from then through last July, but has lost about 60% in the ensuing three months. It's now down to about where where it was when Pearlstein first charged that short-sellers were out to "prevent investors from seeing the strength and progress" in the company.

The average investor may regard short-sellers with suspicion, too, because only professionals with lots of capital and iron constitutions can be shorts. A buyer of a share--a "long"--has unlimited profit potential but limited downside, since a share can only decline to zero; a short-seller has limited upside, since his borrowed shares can only decline to zero--but unlimited risk, since every dollar of gain in a shorted stock represents a loss to a short, and a stock theoretically can keep rising indefinitely.

Truly smart investors know shorts are necessary. Here's Josh Brown of Ritholtz Wealth Management and the Reformed Broker blog: "Short-selling is good for the market, and it's been an essential ingredient for American capitalism since the beginning.... Short-selling can be abusive but so can anything else – buyers can be manipulative too and no one is looking to outlaw buying."

He's right. No market can function effectively if it's dominated by buyers pushing a story of a cloudless future for every stock. But that's about as healthy for investors as a diet consisting exclusively of Twinkies and candy corn would be for you or me. It's fun for a while, but it ends in diabetes. If you want an example of what can happen without shorts to cast a questioning eye on investments, consider the story of Theranos, the Silicon Valley start-up hawking a supposedly "transformative" blood-test technology.

In the private venture investing market unsullied by short-sellers, Theranos rode its unchallenged claims to a putatuve valuation of $9-billion--and then the Wall Street Journal issued a devastating critique. No one will know until the firm next attempts a venture funding round, but it's a fair bet that its subsequent valuation may not be $9 billion.

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Short-sellers are like Kryptonite to hype. If Theranos were a public company, it's possible that short-sellers would have taken a close look at its prospects and attached some lead weights to what looks like a helium-fueled valuation.

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Shorts deserve credit for being first at publicizing some celebrated frauds and flaws in public stocks. Chanos sounded an early alarm over Enron, and put his money behind his (accurate) prediction that China's true growth prospects didn't warrant the unlimited euphoria. More recently, he's been casting doubts about Elon Musk's Tesla Motors.

Shorts aren't always right, but neither are longs. What's crucial is the balance they bring to the markets. All investors should sleep better at night, knowing that since cloudless skies exist only in fairy tales, an army of short-sellers is out and about, keeping watch for storms on the horizon.